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The direct benefit for Dragon Mountain Gold Limited (ASX:DMG), which sports a zero-debt capital structure, to include debt in its capital structure is the reduced cost of capital. However, the trade-off is DMG will have to adhere to stricter debt covenants and have less financial flexibility. While DMG has no debt on its balance sheet, it doesn’t necessarily mean it exhibits financial strength. I will take you through a few basic checks to assess the financial health of companies with no debt.
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Does DMG’s growth rate justify its decision for financial flexibility over lower cost of capital?
There are well-known benefits of including debt in capital structure, primarily a lower cost of capital. Though, the trade-offs are that lenders require stricter capital management requirements, in addition to having a higher claim on company assets relative to shareholders. The lack of debt on DMG’s balance sheet may be because it does not have access to cheap capital, or it may believe this trade-off is not worth it. Choosing financial flexibility over capital returns make sense if DMG is a high-growth company. DMG delivered a negative revenue growth of -11%. While its negative growth hardly justifies opting for zero-debt, if the decline sustains, it may find it hard to raise debt at an acceptable cost.
Can DMG meet its short-term obligations with the cash in hand?
Given zero long-term debt on its balance sheet, Dragon Mountain Gold has no solvency issues, which is used to describe the company’s ability to meet its long-term obligations. But another important aspect of financial health is liquidity: the company’s ability to meet short-term obligations, including payments to suppliers and employees. At the current liabilities level of AU$503k liabilities, it seems that the business has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 5.21x. Having said that, anything above 3x may be considered excessive by some investors. They might argue DMG is leaving too much capital in low-earning investments.
Next Steps:
DMG is a fast-growing firm, which supports having have zero-debt and financial freedom to continue to ramp up growth. Since there is also no concerns around DMG’s liquidity needs, this may be its optimal capital structure for the time being. Moving forward, DMG’s financial situation may change. This is only a rough assessment of financial health, and I’m sure DMG has company-specific issues impacting its capital structure decisions. You should continue to research Dragon Mountain Gold to get a better picture of the stock by looking at: